Carbon Might Be Your Company’s Biggest Financial Liability

Although the price of carbon is currently zero in many areas, it is unlikely that it will remain so for very long. Many companies have hidden liabilities. Executives can use several steps to cover their carbon short position. They should first measure the position in carbon terms. Next, determine the time and price of carbon. Finally, price out future emissions. Then discount carbon cash flows using your company's cost of capital. This will allow you to discount future carbon prices and calculate the economic impact in current dollars. These calculations should be shared with investors by executives in quarterly reports.
It seems certain that carbon will eventually get a price around the globe through a combination of government intervention as well as the development of carbon trading market. A carbon price was proposed in several bills to Congress. However, other mechanisms such as a cap on the emissions of a particular sector or geographic area would have the same effect. Based on economic models and the EU Emissions Trading System's experience, a price for CO2 could be anywhere from $50 to $100 in the short term. It would then rise over time. Five percent of the world's economy would be affected if it were to cost $100 per ton. This is a significant percentage of the global economy. But where is this liability? With the world's corporations.

Corporate climate activists often think that acting on climate plans will be the next CEO's job. However, every company has a Carbon Short position that is based on its emissions. It needs to acknowledge this hidden liability now. The short position is caused by carbon emissions from their operations (Scope 1 & 2, according to climate accounting), as well as their products and/or services (Scope 3). These emissions, which are priced at zero today, but were priced at zero last fiscal year, don't pose a liability for most companies. It is therefore natural that they will continue to be priced at zero in future. It could be said that companies are participating in the carbon futures markets, as they assume that this fundamental input cost won't change. Anybody who has worked in commodity markets will know that unexplored positions can quickly turn from profit to loss.

Nicholas Kukrika (Partner at Generation Investment Management) says that companies must manage their carbon exposure. There is not enough time to do this if companies begin mitigating these risks now. While corporate executives may be tempted wait for more affordable technologies, there are still projects that make economic sense at current low carbon prices.

ExxonMobil is an example of how this can affect a company. Engine No. 1 recently replaced three of the company's board members with a small activist investor. 1. This was due to its inability to recognize the importance of energy transition and make fundamental changes in its strategy, capital allocation decisions, and other factors. Why were investors so angry? ExxonMobil produced 112 million metric tonnes of CO2 equivalent in 2020 (alongside carbon, they also released methane and other greenhouse gases). They would be liable for $11B each year on their own emissions if they were to emit $100 per ton. The company has only earned $8 billion per year on average in the last five years. This would quickly make them bankrupt. This is surely a great way to get their attention. The company's share of the $60 billion annual price tag for Scope 3 emissions, which is roughly 600 million tons (it's not clear how much they could pass onto purchasers), makes the situation even worse.

However, some companies are choosing to act immediately. Ryanair is a low-cost European airline. Ryanair, like all airlines, is an existential emitter. This means that there is no substitute for fossil fuels they use to fly passengers. You can hear a vision for the future by listening to their FY2021 earnings conference call on May 17, 2021. They emitted 150 million tons of carbon in 2020. The EU market price for a ton of CO2 has increased by two-fold since then. They have CO2 options to protect that exposure, so it won't make the 10% profit one analyst estimates.

Ryanair is determined to gain a competitive edge due to its fuel-efficient fleet and emphasis on operational efficiency. Ryanair claims that every passenger who chooses Ryanair over a legacy carrier will reduce their environmental footprint by half. They believe that price competition and branding will help them to gain market share as carbon prices rise. Michael OLeary, Group CEO, stated that they want to achieve zero carbon emissions by 2050. Additionally, they plan to continue to reduce fuel consumption and make Ryanair more environmentally friendly.

Companies should begin to reduce their carbon footprint today. Here are five steps:

The carbon position can be measured in terms of carbon. Calculate the total carbon emissions and carbon intensity (numbers of tons per dollar in revenue) for the company's operations and supply chains. Scope 1, 2, 3 emissions calculations will soon be required. Without any capital projects, calculate if carbon intensity will rise or fall as revenues rise and model future emissions. It is important to determine the prices and when they should be used. Assuming prices of $50 in 2022 and $100 in 2024, $200 each in 2026 and $300 each in 2028 is a good starting point. This is just one example of a forward-price curve. Scenario analysis could use many. To calculate the annual cost of the forward emissions, multiply the forward price by each year's emissions. To discount future carbon prices, use your company's capital cost to calculate a total economic impact today in dollars.

The company can determine which capital projects will have the greatest economic impact on its business and decide which carbon emissions it wants to avoid. There will be efficiency projects that can make economic sense even with a low carbon price. Others will have low capital-intensity projects that can be started quickly to reduce emissions as future prices rise. There will also be projects with higher capital intensity that can be started now, but must be triggered only when carbon pricing and timing are clearer. Some companies may choose to offset, but these are uncertain and pose significant risks.

Although the price of carbon is currently zero in many areas, it is unlikely that it will remain so for very long. It is important to recognize each company's carbon short position at different carbon prices. This recipe will help management and board make the necessary adjustments in strategy and capital allocation to transition to a net zero world. This will be even stronger if the company explains to its investors what it is doing. The company should first explain its five-step approach and then describe efficiency and capital expenditure projects. These steps, if done correctly, will result in a reduction of carbon intensity and absolute emissions as well as protection of shareholder value in a world that is decarbonizing.

Each company's progress in managing their Carbon Short should be reported to the earnings call on a quarterly basis. Companies must have a long-term strategy to reduce their carbon emissions by becoming net-zero by 2050. However, they should also provide short-term updates about the risks they face as well as the progress made on their plan. This is not the job of the next CEO.

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